Why We Never Take the Deficit Seriously

With passage of the Fiscal Cliff legislation in the House of Representatives, the predictable grumbling from self-declared “deficit hawks”, especially those in the Tea Party, has begun.

Cries of cowardice and hypocrisy abound.

Why did Congress avoid the “hard choices”?

Where is the leadership?

Didn’t Obama claim he would cut the deficit in half when he first ran for President?

Of course, none of this is new. We hear the same charge after all deficit debates. The out-party in Washington always makes a hue and cry about the deficit – it was Walter Mondale, of all people, who raised it as a paramount issue in 1984. He was responding to a new pattern that had set in in the early 1980s – the Federal government increased spending on domestic and defense programs AND cut taxes across the board. That the revenue received never came close to matching outlays convinced many supply side conservatives that the real problem was spending – not taxes. Democrats, by contrast, argued that tax cuts were what drove the deficits of the 1980s and, again, in the 2000s. And each side had its version of voodoo economics to justify the epistemic closure surrounding budgetary policy. For Dems it was the Keynesian multiplier effect, which would use government spending to stimulate the economy and, in turn, drive enough private sector growth to fund the government. For Republicans, tax cuts would unleash the full productivity of the private sector and would yield tax revenues – even at lower rates – to cover the Federal government’s expenditures.

Both versions turned out to be wrong – or more accurately, grossly insufficent. Lower taxes may have helped stimulate growth in the early 1980s, but they did little or nothing in the 2000s except to exacerbate the wealth differential and inflate a housing bubble. Meanwhile, government spending may have eased the pain of recession in 2008 but did little to overcome major defects in the credit and housing market that prevented households from driving the economy to growth again. And so we set up a fiscal cliff to force both sides to give in and take ourselves into something like European-style austerity, despite the horrendous consequences of such tax increase-and-spending cut policies for the EU.

But the politics of “cowardice” made sense. The members of Congress who merely tinkered around the edges of the fiscal cliff and kicked the entitlement reform can down the road may have been responding to the reality of the deficit’s threat to America’s economy today: a minimal and mostly abstract threat.

As Bruce Bartlett convincingly argues, the Federal budget deficit provides very little concrete pain for the American economy right now. The evidence is threefold. Interest rates are near zero, which suggests that US Government treasuries are still considered the safest investment on earth. A debt ceiling fight might blow up the nation’s credit rating – it is more akin to a refusal to make one’s monthly credit card payments – but it signals nothing about the inherent soundness of the US dollar and US treasury bonds. There is simply no crowding out effect going on and there hasn’t been since the early 1980s. Added to this is the continued low levels of inflation. The result is that the Federal government can continue to borrow money indefinitely to pay its obligations because the US government can simply print more money without any real fear of inflation. The third piece of evidence – the emergence of the US dollar as the world’s fiat currency – shields the US government from a Greece-style meltdown.

Dick Cheney was right: Deficits don’t matter. We can borrow and spend knowing that the deficit and cumulative debt is mostly an abstract problem. For now, at least. And likely for the foreseeable future.

But it wasn’t always this way. The inflation problem in the 1970s and high interest rates at the time served as a check on government behavior. Federal borrowing really did crowd out private lending and investment, leading to a spiraling downward of the economy. The Paul Volcker-driven anti-inflation policies at the Federal Reserve finally whipped inflation. But the deficit continued as a real threat as nobody could be certain that inflation would stay in check. Globalization, however, prevented the return of inflation and stimulated productivity gains. The Federal government approached the deficit problem seriously in the 1990s because of the hangover of the early 1980s and the once-concrete effect stagflation had on the economy. Deficit fighting was a concrete response to a supply side problem – the cost of business was just too high. Alas the Reagan Revolution, the Clinton tax rates, and the Gingrich Revolution.

But this isn’t 1980 anymore. Our economic woes are mostly on the demand side, as indebted consumers have little money to spend – even though corporations continue their run of profitability. The argument that the deficit somehow limits the US economy RIGHT NOW just doesn’t make analytical sense.

So why do we even have this conversation about deficits? For one, we solved the budget deficit problem not all that long ago and we cannot imagine why it so difficult to do so again. Tax increases, spending cuts and unusually robust growth in the 1990s pulled the Federal budget into the black for the first time in recent memory. Surely a similar tack could work again if only Congress took the deficit seriously.

The political utility of the deficit is mostly as a cudgel to advance other economic priorities – Democrats for higher taxes on the wealthy to limit stratification, Republicans for lower social welfare spending to discourage “dependency” and its related social ills. It rarely is about the deficit. There is no major constituency for the Simpson-Bowles plans of the world because the pain of high deficits just isn’t very real.

But for how much longer will that be the case? Surely at some point the flood of newly printed dollars will lead to inflation and resulting higher interest rates. We may not be Greece now, but we could be something like England in the early 20th century. For centuries the British pound, backed by gold, maintained stability in world credit markets. American attempts in the 19th century to cut taxes had very real and painful financial consequences. As historian Scott Reynolds Nelson points out, the 1893 Depression was caused, in large part, by the drop in US gold reserves after Congress eliminated the sugar tariff. The US was simply not ready to stand in as a stabilizer of global finance. But the combined effects of two World Wars and the collapse of a global empire pushed Great Britain off its pedestal. The gold-backed dollar became the world’s most stable currency. And after 1971, the fiat dollar emerged as the global currency of choice. The consequences of this shift took many years to materialize – oil shocks and, yes, large scale Federal deficits, encouraged inflation and stagnation. But by the 1990s global trade, new technology, innovative (if often dubious) financial instruments, and an increasingly inter-connected global financial system gave the US government the space to do whatever it wished, regardless of the red ink on the Federal balance sheet.

So will that continue? The financial crisis of 2008 should have woken people up to the perils of the global quasi-Ponzi scheme of high finance. Assumptions about continued growth in housing prices fueled trillions of dollars in shady investments. The TED spread was high enough in 2007 to indicate something amiss in Federal Reserve policy. Interest rates SHOULD have been higher with all the housing defaults coming through.

The recovery of financial markets has done little to change behavior, however. And potential rivals – China, the EU, India, Japan – continue to base their own economies on the essential soundness of the US dollar and the stability of the US treasury bond. Like the axiom that housing prices always go up, or the once epic strength of the pound sterling and the Bank of England, nothing is truly permanent in the world of finance. There will eventually be a day of reckoning when creditors lose faith in the US treasury. But until that day arrives – or comes anywhere near – American politicians will continue to kick the Federal deficit down the road.

Higher taxes and a staggered reduction in spending are the order of the day. The govt can’t simply stop spending $1Tn over and above what it brings in without tanking the economy. Or at least it can’t stop spending less than $3Tn total, if the revenue increases. Baby steps folks.

The government “could” continue its profligate spending for some time, provided that congress and the Federal Reserve coordinated together (along with the Treasury Department) to put the brakes on whenever (and if ever) inflation started showing itself to be a problem. The MMT folks have had it right all along. Sooner or later some smart politician will let the people know this and we can get on with our lives and the “normal” functioning of the U.S. government.

“Robert Rubin, a former Treasury secretary under President Bill Clinton who mentored both Summers and current Treasury Secretary Timothy Geithner, warned that investors could demand unsustainably high interest rates as soon as next year if the government does not agree to a 10-year debt reduction plan.”

“I think the probability of a serious set of adverse effects as a result of our fiscal situation, if we don’t address it, at some unpredictable time is extremely high, and one of the kinds of effects it would have is a severe bond and currency market crisis. And whether that’s a year off in time or five years off in time or 10 years off in time is absolutely unpredictable,” Rubin said.

“One thing I can tell you for sure — and I have watched markets my entire adult life — is markets can change dramatically, and it’s almost instantaneous and with no notice. And I think it is imperative to react. And I think the probability of a crisis increases as time goes on.”

Surely at some point the flood of newly printed dollars will lead to inflation and resulting higher interest rates.

Not necessarily. The MMT folks do know better than Rubin and others who look to the past and never look past their assumptions, IMO. Economists who look past assumptions are rare. It’s not very hard to find people who make the claim that “printing money” will inevitably lead not simply to inflation, but hyperinflation. But studies have shown that all other things being equal in a politically and economically stable country that isn’t what happens. For one thing the money supply needs to exceed the nation’s production capacity by enough so that there just isn’t any way for productivity to fulfill that demand. That’s actually harder to do than you might think. In fact, for it to lead to hyperinflation you pretty much have to have had a massive shock to the system, generally an external one. Even for enough inflation to just cause significant problems we’d have to print an astonishing amount of money because our economy has a huge amount of slack in it now and has had slack since the dot com bubble burst, much less the massive collapse produced by the housing bubble and financial collapse.

If we just went ahead and printed the money to finance the most important infrastructure needs we have I think that we could quite possible provide a major boost to employment, our economy and in fact reduce the deficit not by printing money to put directly into the financial system but instead by taxes on the businesses doing the work, their employees and the people and businesses who would be selling them products all without increasing inflation to a worrisome level.

“Right now, deficits don’t matter — a point borne out by all the evidence. But there’s a school of thought — the modern monetary theory people — who say that deficits never matter, as long as you have your own currency.

I wish I could agree with that view — and it’s not a fight I especially want, since the clear and present policy danger is from the deficit peacocks of the right. But for the record, it’s just not right.

The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail. As long as those conditions DO prevail, it doesn’t matter how much the Fed increases the monetary base, and it therefore doesn’t matter how much of the deficit is monetized. But this too shall pass, and when it does, things will be very different.”

“One thing I can tell you for sure — and I have watched markets my entire adult life — is markets can change dramatically, and it’s almost instantaneous and with no notice. And I think it is imperative to react. And I think the probability of a crisis increases as time goes on.”

This statement by Rubin is not based on assumptions…it is based on empirical observation.

Economic recovery could bring a disaster in itself. US debt service is only around 6% of the budget, because it’s paying historically low interest right now, about half of normal rates. If interest rates even approached normal on US debt, the amount paid to interest would double, causing an even higher deficit.

But the bigger problem will be facing the Fed. Right now, they’ve been using the extra money that they created to buy US bonds (at those historically low rates) and mortgage backed securities (to detoxify the bank balance sheets). The Fed’s main method of fighting that inflation is to sell the assets on their balance sheet, in order to mop up the money that they were spending. The problem is if inflation gets started, no one’s going to want either of those assets and the Fed will have to sell them for a lot less than they paid.

Also, just as buying massive amounts of US debt has lowered the price of borrowing, attempting to go from a buyer of bonds to a seller would spike the interest rates that the government is paying, which would quickly create another deficit crisis, since most US debt is in short-term bonds.

We can’t fix the budget without a recovery, but we might also be unable to fix it with one.